Adam Smith: 17231790 Wealth of Nations: 1776

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Adam Smith (1723-1790)Wealth of Nations 1776
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Smiths Home TownEdinburgh, Scotland
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Todays topics

• The efficiency of competitive equilibrium
• Finding a competitive equilibrium

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How did you get to UCSB today?

• Walked
• Rode a bicycle
• Skateboarded
• Drove
• Used Public Transportation

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How long is your commute to UCSB?(in miles,
round to nearest mile)
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A demander with Buyer Value 50 buys an object
from a supplier with Seller Cost 20. The sum of
the buyers and the sellers profit

• depends on the price. Higher price means larger
  sum.
• is the same at all prices between 20 and 50.
• depends on the price. Lower price means smaller
  sum.
• None of the above.

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Why is that?

• Buyers profitBV-Price
• Sellers Profit Price SC
• Buyers Profit Sellers profit
• (BV-Price)(Price-SC)BV-SC
• So sum of buyers and seller profit is BV-SC
  regardless of price.

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Clicker test

• Press the button A on your clicker.

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One more test

• Enter the number 12501 with your clicker

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Adam Smiths Big Idea Efficiency of Competitive
Markets

• Every individual neither intends to promote the
  public interest, nor knows how much he is
  promoting it. He intends only his own gain and
  he is in this led by an invisible hand to promote
  an end which was no part of his intention.
• Adam Smith, Wealth of Nations, 1776

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What did Smith mean?

• He said markets promote the public interest.
• What is that?
• A modern interpretation Competitive equilibrium
  is efficient.
• In the case of our experimental markets, this
  means the competitive equilibrium outcome
  maximizes total profits over all possible
  allocations.
• This does not mean it maximizes every
  individuals profits---just the sum.

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Efficient is not the same as fair

• An outcome can be efficient, but grossly
  inequitable.
• A system that gives almost all of the benefits go
  to only a few people would not be satisfactory to
  most people, even if it is efficient.
• So why do we care about efficient?

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Efficiency and the size of the pie

• A system is efficient if it maximizes the amount
  of resources to be divided.
• If a pie is made larger, it becomes possible
• to give everyone a larger piece.
• But of course it is also possible to increase the
  size of a pie while reducing the size of pieces
  given to some.
• Efficiency is about the potential for mutual
  gain.

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A Dramatic Proof

• We are going to act out a proof of the efficiency
  of competitive equilibrium.
• We need
• 15 volunteers in dark shirts
• 15 volunteers in light shirts
• 2 accountants

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Trade as matchmaking

• Dark shirts are buyers. Height of a buyer (in
  inches) is his or her Buyer Value.
• Light shirts are sellers. Height of a seller
  (in inches) is his or her Seller Cost.
• A trade is a match between a dark-shirted
  buyer and a light-shirted seller.
• Total profits (or loss) from a match are the
  difference between the height of the dark shirt
  partner and that of the light shirt partner.

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Random matching

• First we pair light and dark shirts at random and
  have them trade only if the dark shirt is
  taller than the light shirt.
• Accountants will measure the total profits from
  these trades.
• How many trades were there?
• How much was total profit?

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Maximizing total profits

• How could we arrange partnerships to maximize
  total profits?
• One idea Pair tallest dark shirt with shortest
  light shirt, second tallest dark with second
  shortest light, and so on until the next dark
  shirt is shorter than the next light shirt.
• Other ways?

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Living Supply and Demand Curves

• Line up Dark Shirt demanders in order of height,
  facing the class, with tallest at left of class.
• Line up Light Shirt suppliers in front of the
  demanders in order of height, facing the class,
  with shortest at left of class.
• These form a demand curve and a supply curve.
• Where do the curves cross?
• Suppliers turn and face demanders. You make a
  trade if Dark Shirt is taller than White Shirt
  partner and otherwise not.

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What is the total amount of profits?

• Our Accountants will measure distances between
  buyer heights and seller heights and add them to
  compute total profits.
• Could profits be increased by rearranging
  partners among those who trade?
• Could total profits be increased by adding more
  trades?
• Could profits be increased by exchanging somebody
  who traded with somebody who didnt?

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What is the price?

• How tall is shortest dark shirt who got a
  partner?
• How tall is tallest light shirt who got a
  partner?
• Let p be any number between these two heights.
• How is p like an equilibrium price?
• Suppose that we announced price p and said that
  anybody could buy or sell at price p.
• Who would buy and who would sell?
• Who would neither buy nor sell?

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Market Limbo

• Line up dark shirts at left of stage, light
  shirts at right.
• Accountants hold a broomstick 3 lower than
  equilibrium height.
• Everyone from either side who can walk under the
  broomstick without stooping must do so.
• Trades take place at left side of the room.
• Is there excess demand or supply?

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Now too high

• Return to original positions, Dark shirts on
  left, light shirts on right.
• Set the broomstick 3 higher than equilibrium.
• Everyone who can walk under without stooping goes
  to other side.
• Is there excess demand or excess supply on the
  left side of the room?

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Getting it jussst right

• Return to original position.
• Set broomstick at equilibrium height.
• Everyone who can walk under does so.
• Now supply equals demand.
• Every dark shirt on left is taller than every
  light shirt on left.
• All could profit by trading at equilibrium price.

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Could profits be higher than competitive
equilibrium profits?

• Could we increase total profits without changing
  who the traders are but rearranging who trades
  with who?
• Could we increase profits without changing number
  of trades by exchanging some non-traders for
  traders?
• Could we increase profits by having more trades?
• Could we increase profits by having less trades?

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Maximizing number of transactions

• Choose a broker, who gets a 1 commission on
  every trade.
• Broker can pair people up, but they will trade
  only if the dark shirt is taller than the light
  shirt.
• How should he do it? Can he make more trades
  than the competitive number?
• Will total profits be higher or lower than in
  competitive equilibrium?

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What have we done

• Shown how to prove that competitive equilibrium
  maximizes sum of gains in a simple demand and
  supply economy.
• A generalization is true in economies with many
  simultaneous markets. That is proved in more
  advanced courses.
• Shown how adjusting prices equilibrates supply
  and demand.
• Price as a limbo bar
• Shown that competitive equilibrium does not
  necessarily maximize number of profitable trades.

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Assignment

• Before class on Wednesday
• Read Bergstrom and Miller Appendix A.1-A.4 and
  McAfee Chaps 2.2-2.4
• Do Excel exercises on demand for iPods and
  iPhones (Link on class web page)
• Before your section meets
• Read instructions for Experiment 2

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And were out of here